Markets have already begun pricing in the possibility that President Trump’s pro-growth policies may see hurdles. But three key cohorts still have upside potential.

Since the presidential election we have gone through many stages of Donald Trump and his administration. While I’m not sure we are yet at the “acceptance” stage, it does seem like there is at least a lull in the media hyperbole, some of which may be related to the more restrained behavior of the president himself.

In other words, people seem to at least be getting used to Donald Trump as president.

However, there has also been a discounting process ongoing with respect to the president’s ambitious pro-growth agenda of lower taxes, reduced regulation and deficit spending on infrastructure. This, too, is weighing on the bullishness of many assets tied to these policies, not to mention the confidence of market participants and strategists.

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This discount seemed to reach new heights when, lacking the votes on a Republican plan repeal and replace Obamacare, the House leadership did not allow the bill to come up for a vote. Many are citing this as a repudiation of Trump and his administration’s ability to legislate, and conclude the pro-growth policy is less likely to get done. Our view is that the market had been discounting that possibility for months and the health care flop may simply be the point of public recognition. A closer examination reveals this much more discriminating opinion by the market all year.

Our view at Morgan Stanley’s Global Investment Committee is that the markets were already discounting the very powerful cyclical upturn in the global economy by the time the U.S. election took place.

While the Trump/Republican win can accurately be described as a surprise to a large majority of individual market participants, the real impact could be seen in three key cohorts: banks, which would benefit from deregulation; small-cap stocks, potentially big winners from tax reform; and deep cyclicals, which stand to gain from infrastructure spending.

A few observations: First, the relative outperformance of all three began long before the election, largely due to the cyclical upturn in the global economy, though some might have been due to the likelihood of a Trump victory seeping into the broader market. For deep cyclicals and small caps, their relative outperformance began almost simultaneously with the cyclical trough in global growth in January 2016. Financials didn’t bottom until after the Brexit vote and the final collapse in bond yields that took place in early July.

Second, all three cohorts enjoyed an additional boost from the Trump turbocharge following the election, but they peaked in late December as the market began to question the ability of the incoming president’s ability to legislate rather than pontificate.

Finally, both small caps and deep cyclicals have given back almost all of their post-election relative performance while banks have ceded about half. This makes sense to us because financial deregulation doesn’t require legislative support the way tax reform and fiscal spending do. In other words, the market is putting very little value on Trump policies that require legislation. Meanwhile, emerging markets and health care stocks have done great this year, which suggest the market is not been worried about protectionism or the repeal of Obamacare. Rather than “bad Trump” getting priced, it’s more like “ineffective Trump.”

Still, we think there will ultimately be progress on tax reform and deregulation this year even if it takes longer and may be on a smaller scale than originally expected. In the context of what has been discounted by the market at this point, this will be viewed positively and we don’t think this is a big significant risk to equity prices at this point. As a result, we suggest adding large-cap banks, small- and mid-cap stocks, and deep cyclicals like industrials and materials stocks which are levered to the acceleration in global synchronous growth.

Note: This article first appeared in the April 2017 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

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Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

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